Chinese stock market cools off
by William Baunton
Shares in Shanghai experienced a strong bull market run since the end of 2014, with stocks on the Shanghai Composite Index rising 150% in value in under a year. But it all came to an end in June, with the bursting of what looked like an unsustainable bubble.
Curbing the resulting stock market decline, and clearing up the aftermath of massive support purchases of Chinese shares, presents the Communist party leadership with a major headache. The difficulty of policy-making in a harsh external environment could represent an important hurdle for further financial liberalisation.
On 12 June, when the Shanghai Composite hit a seven year high of over 5,100, the euphoria of the bull run turned to scepticism. Some shares were trading at 100 times earnings, with the market on average trading at about 20 times earnings. Amid awareness that prices had been bid up to artificial highs, sentiment swung from uneasiness to near-panic as stocks plummeted. Frenzied selling since 12 June wiped more than a third off the Shanghai Composite, which hit a low point of around 3,500 on 9 July.
With the economy slowing and the renminbi too high for the comfort of many exporters, the disconnect between economic fundamentals and prices at the peak was clear.
Although the People’s Bank of China has mainly used interest rate reductions and lower reserve requirements to ease policy, there is speculation that it may turn to further unconventional action if unrest on financial markets continues. The authorities may possibly need to undertake quantitative easing (on a scale that could be the largest in the world) to soften the landing,
The government’s intervention in the stock market to halt the sharp correction appears, at least for now, to be working. The big uncertainty is whether this action is sustainable. Initial measures, such as banning stock sales by major shareholders appeared initially to have little effect. However, state-owned banks have been shown to have provided over $200bn to the China Securities Finance Corporation for lending on to brokerages to help restrain the stock decline. The biggest of these loans appears to have been from China Merchants Bank, the sixth largest lender by assets.
Stocks have now stabilised, with the Shanghai Composite recovering 20% since its 9 July low. Regulators have launched investigations to spotlight what they describe as ‘malicious short selling’, seeking out traders supposedly carrying out bearish bets on inside information or with intent to influence prices.
The relatively underdeveloped stock market has experienced a bubble before. In 2007, in similar though more extreme fashion, stock prices in Shanghai more than tripled in less than a year. The Shanghai Index reached an all-time high of just over 6,000 in October 2007. Within six months, as can be seen in the Chart, almost all these gains were wiped out.
Today’s turbulence shows strong parallels, with high price-earnings ratios (although nowhere near the heights of 2007) sparking abrupt changes in sentiment when certain price barriers are breached. Back then, the level on the Shanghai Composite triggering aggressive profit-taking was 6,000. This time, based on events in June, it appears to have been 5,000.
Many market participants are pointing to the cooling real estate market as the reason behind the bubble. With the property market down over the last year, investors diverted capital to stocks – aided by looser monetary policy and increased lending by banks.
The big questions are how much further stocks need to fall to be ‘correct’ and what will be the effects on global markets. Stocks in Hong Kong have already felt the drain on liquidity. As of 8 July, the Hang Seng index downturn had wiped off all 2015 gains in a matter of days. It has since recovered some of these losses.
The Chinese equities decline has been a major factor pushing down commodity prices. China’s slowdown has led to expectations of declining demand. Nickel, zinc and iron ore are trading at their lowest levels since the financial crisis. The convulsions have added to the effects of a general commodities glut. Chinese investors are rushing to exit commodity positions to raise cash. Investors are hoping that a combination of weak commodities, concern about slowed liberalisation, and China’s competitive difficulties caused by the strong renminbi will not spill over to cause worldwide turbulence, as was seen in February 2007.
At the time, Chinese markets were almost completely shut off to outside investors. Now, China is becoming more open through initiatives such as the Shanghai-Hong Kong Stock Connect and measures to enable two-way flows of investment with the rest of the world. Chinese stocks should be watched closely for signs that turbulence could spark wider upheavals. ■ Back